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Bad-Mouthing the Bubble

Fool readers speak out about risky loans and inflating prices.

One of the most rewarding parts of writing for the Fool is the email we get from our readers. In the past couple of months, nothing I have written has drawn more responses than a pair of articles about housing-bubble babble and the dangers of "interest-only" and "pick a payment" adjustable-rate mortgages.

The first piece was spawned by a simple observation about a pair of newlyweds who had signed on for a very large mortgage loan that would endanger their financial future. They didn't even realize it until they did the math -- after they'd signed on the dotted line.

Unfortunately, many people are far more financially analytical when they're shopping for an MP3 player or a dishwasher than when they're purchasing a home. It takes more than a little time and effort to figure and compare the true costs of a mortgage. Believe me, I've been there and done that. It's a lot easier when you can eyeball the price tags at Lowe's(NYSE:LOW) or Home Depot(NYSE:HD). When you finally pay up for that Platehoser 2000 or an pick up an iPod from Amazon(NASDAQ:AMZN), you don't have to pay points or closing costs or put taxes in escrow. And if you're financing it on your credit card, you'll already know the interest rate and be able to figure the costs of borrowing.

It gets even scarierBut another part of the problem, I suggested, was the aggressive marketing of these high-risk "interest-only" and "pick a payment" (often negatively amortizing) adjustable-rate mortgages (ARMs) toward people who are not only ill-suited for them financially, but also unlikely to be made aware of exactly what can happen when the low, up-front "teaser" rates disappear. Add to it the perfect storm of overheated housing markets, with real estate agents and colleagues telling everyone to "get in before it's too late," and you have a recipe for bad, bad things.

Revenge of the righteousMy first piece drew quite a few hisses from real estate agents and lenders who accused me of using of "scare tactics," but the second piece had the opposite effect. Sure, I got a few more protests, including one from a banker who claimed her employer did not offer interest-only mortgage ARMs -- a claim I could confirm as false by a five-minute trip to its website.

But I got far more letters from industry professionals who share my concerns and are quite evidently worried for their customers as well. These responses came from across the financial spectrum, from owners of small mortgage-banking firms to employees of enormous corporations like Citigroup(NYSE:C) and Bank of America(NYSE:BAC).

Though the latest batch of email confirms my suspicions that there's a lot of shady business being done, it also gives me great hope, because it proves that there are plenty of good people out there who are determined to help homebuyers make Foolish financial decisions.

T.B., the owner of a mortgage-financing company, says:I have to chastise my fellow mortgage professionals for their money-hungry nearsightedness. The interest only and option-ARM (pick your payment) loans are going to come back to haunt the majority of those who have chosen to use them. The default rates on those homes will be far and above the average.

In all the years that I have been in the finance/mortgage business, I have only done one interest-only loan, and I refuse to do an option-ARM loan no matter how "sophisticated" the borrower is. The potential for negative amortization has no place in my book. The mortgage companies and lending institutions that are heavily promoting these loan programs don't care about the borrower (their customer!); all they care about is making a fast buck.

Take my word for it, Seth, the majority of all the Johnny-newcomer-mortgage-people will be out of business once rates start moving up. Unfortunately, we have to live with them for now. I can only sit here and feel sorry for the majority of borrowers who have been conned into interest-only and option arm programs.

N.C., who works at a large bank, wrote:Last week I was discussing the "pick your payment" mortgage with a friend who related that her daughter and son-in-law had found out the hard way some years ago when they sold their $25,000 house and found that they now owed $40,000 to the mortgage company. Luckily they had been in the house long enough for the equity to cover the loan and leave some for a down payment on a new house. This couple were in no way sophisticated investors, and it came as a very unexpected surprise, as they did not understand the contract they had signed.

This kind of mortgage has been around for a long time, and yes, it is often offered to very unsophisticated, low-income buyers. These are the very people who have no buffer between them and financial crisis. The fact that today's figures are 10 times those in the example above does not change the basic scenario.

D.H., manager of another mortgage-finance company, wrote:I do have available some of the products you mentioned in your article. ... I do take the time to explain the mechanics of them and also the risks associated with such a product. As I state to my clients, "I can't tell anyone what their tolerance for risk is; however, I can in most cases define it with numeric facts."

I think it is going to be very interesting in about three years, when it is time to pay the piper on some of these loan products, and would say that the default rate will be going UP. So thanks for speaking out. Now if I could only find a way to be able to market integrity, I would be set. This really isn't a very fun market as far as I am concerned.

L.C., a credit-services counselor, says:As a counselor at a HUD-approved housing counseling agency, I have been very concerned about seeing people who feel they can "borrow their way out of debt." The local housing market has taken a tremendous jump in the last year to 15 months. I have counseled borrowers who have interest-only, variable-rate first and second mortgages!

Many of the borrowers feel they need to get the loans now. As the home prices have increased, they are concerned they'll be priced out of the market. Also, the housing market has been hit by people who find our area a great place to "invest" in the housing market. My thought is that [the next] year to 18 months will be a defining moment for these borrowers.

Fool me twice? Not if I'm a Fool.Financial-industry insiders weren't the only ones to respond. I also got many notes from regular people who'd been burned in the past by loans that sounded too good to be true, along with others who are just trying to work toward a better financial future.

P.B. compared the "name your price" home loans to car-lot shenanigans:I learned a hard lesson from a car dealership years back when they had me so focused on my monthly payment I forgot what I was really paying. They had extended my loan one whole year (six years total) to make the payment what I wanted it to be. "Presto change-o!" I later realized what a terrible mistake I had made.

Just about anything can be made affordable on a monthly basis, including homes. They are already extending mortgages to 40 years. Soon we will be passing mortgages to our kids and grandkids.

A.G., from California, who describes herself as a person of "limited intelligence," wrote:My husband and I recently sold and cashed out $180,000 from our house in East Los Angeles with a plan of investing our money in something safe for a few years until things calm down in the housing market and our income goes up. However, we have a smart (those are the worst kind) Realtor who has us looking into duplexes. We put in a bid for a small duplex and were supposed to increase our bid later today.

Our Realtor's wife, a loan officer, has been running the numbers and conveniently suggesting "programs" such as seven-year fixed, interest-only, and choose-your-payment. We really only could afford the mortgage payments for two years, and then our savings would be wiped out, and the rents still would not cover this place.

Foolish bottom lineI closed with A.G.'s remarks for a reason. It's clear that A.G. has underestimated her intelligence. And even if she's no smarter than the average bear, she is more vigilant, and that's even more important. Rather than simply trust the good-looking numbers and give into pressure, she took the time to do the math herself, saw what it would truly do to her finances, and made a decision accordingly. That's the only Foolish thing to do, and it's something we can help you with via our collection of financial calculators.

And allow me to put on my rain cloud costume for one final thought. Although I don't like to invest based on macroeconomic data -- or worse yet, macroeconomic predictions -- Fools should keep in mind that recent economic numbers suggest that household income in the U.S. is rising not because of wage increases, but because of inflated home equity.

Any big change in this situation will inevitably trickle down into other parts of the economy, for the simple reason that a home is not cash. A home will not pay for that new work suit at Nordstrom(NYSE:JWN) or get our kids their organic OJ at Wild Oats(NASDAQ:OATS) unless we borrow against it. And we simply can't keep borrowing forever.

I'm not calling for everyone to head to the root cellars, but to do the math. Do the math, Fools, and accept only the risks you can afford.

Seth Jaysonwill stick with his crummy rental and money in the bank, thanks. At the time of publication, he had no positions in any company mentioned here. View his stock holdings and Fool profilehere. Fool rules arehere.